Kaplan: Is your lease gross?

Published: Thursday, April 25, 2013 5:30 a.m. CDT

Commercial leases come in many varieties. There are two major categories of leases found in the marketplace. There are referred to as “net leases” or “gross leases.” Allow me to explore some of the differences and nuances between the two.

First, there is a “gross lease.” The landlord picks up the costs or expense of real estate taxes, insurance on the building and exterior maintenance like snow plowing and lawn care. Tenants like this type of lease because it is easier to budget for a known fixed number. Landlords have a love/hate relationship with gross leases as they are simple to do the accounting for but if expenses go up, the entire increase comes out of the landlord’s pocket. This reduces the landlord’s financial returns.

For example, if real estate taxes go up from $10,000 to $12,000 from year one to year two and the rent stays the same, the landlord has to absorb the loss ($2,000) in a gross lease. Some landlords mitigate their exposure to this kind of loss by modifying the gross lease terms. They negotiate what is called a “tax stop” into the lease which means the tenant will pay any increase in the real estate taxes over a base year amount.

In the example above, where taxes went up from $10,000 to $12,000 from year one to year two, the tenant would be responsible for that increase. This is called a “modified gross lease” and there are variations on that approach in the real world. Sometimes a modified gross lease is structured so that the landlord pays real estate taxes and insurance but the tenant pays the cost of lawn care and snow plowing. Since leases are legal instruments that are negotiated between two parties, they can take a variety of forms. The point here is that if you see the term “modified” in front of the word “gross” as it pertains to a lease, you will need to ask for a definition. As in many things, “the devil is in the details.”

Net leases are by nature structured to put the onus of expenses on the tenant. Typically in net leases, the tenant pays a scheduled amount of “base” rent and also pays property expenses such as real estate taxes, insurance and maintenance. In a multi-tenant property such as a strip center or industrial building, the tenant will pay his proportionate share of the property expenses based on the percentage of space he occupies of the total. If he occupies 10 percent of the space, he gets the honor of paying 10 percent of the provable documented expenses.

Net leases vary in their degree of “netness” (I made that term up) in that some require the tenant to pay all operational expenses of the building (often referred to as a “triple net lease”). Then some net leases only require the tenant to pay for real estate taxes, leaving insurance and maintenance to the landlord to pick up.

If all this sounds complicated, it’s really not. If a landlord puts his property on the market for lease, he will tell you if he is asking for a gross, net or some modified version of those. If it is not clear what he is asking, a prospective tenant will simply ask for an explanation or definition.

What is important to understand is that the market determines the level or amount of rents, whether they are quoted as net or gross. In theory, in a given rental market, there should not be much of a difference between net and gross leases. If you take a net lease and “gross it up” by adding real estate taxes, insurance and maintenance to the base rent, the result should look a lot like the gross rents in the market. For example, if $6-per-square-foot gross is representative of a market rent, the net rent equivalent should equal $6, as well. So, if the base rent is $4, then taxes, insurance and maintenance are in the realm of $2 ($4+$2=$6).

If you are in the market to lease commercial space, be aware of the differences in how leases are structured. When supply exceeds demand by a large amount as is currently the case, you will have more negotiating power than when demand exceeds supply. Sometimes landlords who prefer net leases will end up agreeing to a gross lease, just to make the deal happen.

What’s the grossest lease of all? That’s when utilities are included in the equation and the tenant has an all inclusive monthly payment. Then of course you could buy a building and not have to worry about all this.